Bond market rebound: An opportunity not to be ignored

US 10 years treasuries were trading at low yields into 2022

^{Source: Bloomberg From December 2000 to June 2023.}

 

Are bonds worth a closer look?

For government bonds to perform better, it is crucial that inflation decreases from its lofty levels. Encouragingly, since the peak in global inflation, government bond yields have stabilised.

 

Bond yields are closely tied to Inflation

^{Source: Bloomberg}

While Inflation is still high, it has fallen since late 2022. We expect this trend to continue into the second half of 2023, driven by falling energy prices. Further disinflation could be supportive for bonds in the remainder of 2023.

A rosier inflation outlook is likely to see central banks closer to pausing interest rate increases. Historically, a pause in rate increases often coincided with a peak in the US 10-year Treasury yield, as observed in the seven previous rate tightening cycles.

In recent decades, including government bonds to portfolios, has been a sensible way to reduce risk. It has been a great diversifier as bonds have typically been negatively correlated to equities, especially during sharp sell-offs.

To highlight this, JP Morgan sampled returns of 10-year government bonds during periods of acute economic shocks.

Prior to the COVID-19 shock, average returns during these periods were substantial, buttressing clients’ portfolios.

However, bond returns during the COVID–19 market sell-off were far lower. Bond yields were already historically low and so bond prices had much less scope to increase as compared to previous shocks.

Given the sharp losses in bonds in 2022, bond valuations are now more attractive. This improved valuation starting point should allow for bonds to regain their diversifying role in investor portfolios. Recession fears are heightened given the aggressive interest rate hikes. Due to this uncertain back-drop, bonds are better prepared to protect investors in the event of another economic shock. For example, if US 10-year bond yields were to fall by 300 basis points, their total return would be over 25%. This would allow portfolios to better weather an economic shock.

 

Historical returns from 10-year govt. bonds during shocks

%. total return over the period when stocks were failing

^{Source: JP Morgan - 30 June 23}

 

Opportunity not to be ignored

Government bonds are a major asset class and should not be ignored by investors. After a significant fall in 2022, they do warrant careful consideration for inclusion in investor portfolios.

The path of inflation will be crucial in determining the performance of bonds. Stickier inflation could see bond yields rise, leading to further bond losses.

However, considering the attractive valuation starting points, losses are unlikely to be as severe as in 2022. And while inflation is a risk to bonds, there is still a possibility of a recession later this year or in 2024.

Recessions tend to be bad for equities but positive for government bonds. In such scenarios, government bonds could provide portfolios with much needed protection.

Our Investment Committee has started to increase exposure to government bonds. Government bonds offer clients decent income and importantly add diversification to their overall portfolios. We began this process in our Q2 2023 Investment committee series. Learn more about the key decisions we made here.